Investing Versus Debt Pay-off

Perhaps the most common question I get by email, in the blog comments, and on the forum basically boils down to “Should I pay off my debt or should I invest?” I’ve addressed it years ago on the blog, earlier this year on the blog, and hit it hard in The White Coat Investor: A Doctor’s Guide to Personal Finance and Investing,” but I just keep getting it over and over again, so I know it is important to you. I hope to give very concrete guidelines where possible and outline the issues to consider when that isn’t possible. Let’s start with the very obvious.

# 1 Don’t Leave Part of Your Salary On The Table

If your employer gives you a match in a retirement account like a 401(k) or 403(b), then be sure to get it. Not getting it is like rejecting part of your salary. So even if you have terrible, nasty debts, I would still contribute enough to get your full match. Think about it. If you get a 100% match on the first 3% of salary (let’s say that’s $6K) you contribute to the 401(k) then you get an extra $6K. Assuming immediate vesting, even if you turned around and pulled all that money out of the 401(k) and sent it to your lender, you would only pay $1200 in penalties in addition to the taxes you would pay either way. So you’re $4,800 ahead.

# 2 Don’t Pay Off Loans Someone Else Will Pay Off

If you are doing “The PSLF Thing” (meaning you made lots of tiny IBR/PAYE/REPAYE payments during residency or fellowship and are now employed full-time by a 501(c)3 anticipating tax-free forgiveness after 120 monthly payments), then don’t send in extra money to your student loan lender. If you’re worried Public Service Loan Forgiveness will go away, then let that worry motivate you to spend less money so you can divert a large percentage of your income toward building wealth. I’ve traditionally advised people to keep a “side fund” in a taxable account that can then be directed toward the student loans if PSLF gets changed and you’re not grandfathered in. However, it doesn’t make much sense to invest in taxable if you still have tax-protected space like a 401(k) or Backdoor Roth IRA available to you. So I’d probably put it there. Sure, it’s not going to allow you to instantly pay off those student loans in the event of PSLF catastrophe, but you’ll end up wealthier for preferentially using the tax-protected account.

# 3 Stop Digging

Here’s another somewhat obvious point. When you realize you’re in a deep hole (debt), stop digging! I can’t believe how many people are wondering how to get their student loans paid off while still borrowing money to buy other stuff. If it isn’t a modest house or a practice you probably shouldn’t be buying it on borrowed money. That includes cars, vacations, living expenses, boats, pets, or anything else. Professional school will make you debt-numb. Wake up to its wealth-destroying effects on your life! Do you have $400K in student loans? Then you’re likely one of the poorest people in the world. The guy living under the bridge is richer than you. His net worth is $0. You should be driving a beater and living somewhere that feels very middle-class.

# 4 High-Interest Rate Debt Is A Great Investment

If you have high-interest debt, chances are good that you’re not going to be able to find an investment that will make that much money. You don’t borrow money at 20% in order to invest because the risks you would have to take to attempt to beat that return are substantial. Thus, if you have debt at 20%, you should be paying it off as a major priority. And by major priority, I mean instead of eating. It probably wouldn’t hurt you to lose 10 or 20 lbs anyway, would it? In fact, you can probably lower that figure quite a bit. If you’ve got 8%+ debt, you’re probably better off paying that down instead of doing anything else with your money. That’s a guaranteed 8% investment. I wish I could find more of those.

Now that we’ve got those hard and fast rules out of the way, we can move on to some of the more subtle aspects of this question. Let’s look at some of the aspects to consider as you decide how to allocate your disposable income between investments and extra debt payments.

# 5 How Long Do You Want To Be In Debt?

Personally, I think you ought to have your education paid for within 2-5 years of completing your training. You’re really not done with med school until you’ve paid for it. If you go much beyond 5 years, it will feel like a noose around your neck. I mean, you could have had the military pay for it and you would have been done in 4 years. In order to be out of debt that quickly, you’re going to have to direct a substantial portion of your income to it. Calculate out how much that is, and allocate that much toward the debt. Invest the rest.

But what if that doesn’t allow you to max out all the accounts you want to max out? Tough cookies. Take more money from your lifestyle spending (i.e. Live Like A Resident), not from your debt pay down money. That’s not negotiable. You’re getting out of debt in 2-5 years, come hell or high water. Now, if you want to keep your student loans for 5 years in order to max out some retirement accounts when you could get out of debt in 2 without maxing them out, that’s okay with me. But dragging your loans out for 15 years? You’re going to regret that. Those who lived like a resident when you should have will be financially independent by the time you pay for your school. How are you going to save for your kids’ schooling when you haven’t paid for yours yet?

Once your student loans are gone, you can ask yourself the same question about your mortgage. Do you really want to be paying for that stack of bricks for 15-30 years? Figure out when you want to be done paying and make payments large enough to be done by then. Don’t assume you’ll be able to make big huge payments later (although there’s a good chance you will, thanks to inflation, but certainly no guarantee.)

# 6 It Isn’t Just About Comparing Rates of Return

Some people make this topic way too simple. They say, “If your investment is going to earn more than the interest rate of your student loans, then you should carry the loans and invest.” That ignores way too much. It ignores risk. It ignores the effects of taxes. And it ignores other important financial issues like asset protection, estate planning, and insurance costs.

The author’s son demonstrates how risk is generally something you manage, not eliminate at the Utah Olympic Park

Risk

If you can get 8% investing and have 7% loans, you should invest, right? No. Because that 7% is risk-free. And if you want a risk-free investment, you’re looking at only getting 1-2%. If you adjust for risk, paying off those loans is going to be the right choice. Now if you’re comparing an expected 8% return to a guaranteed 2% return, well, that’s a little easier argument to make.

Another important consideration with risk is your need to take it. If you’re a 55-year-old doctor with a net worth of $100K, you have substantial need to take risk (including leverage risk) if you expect to retire with anything close to your accustomed standard of living. If you’re a 45-year-old doctor with a net worth of $4 Million, you can afford the luxury of being debt-free. This consideration had a substantial effect on our decision to pay off our very low-interest rate mortgage in less than 7 years.

Taxes

Some types of debt are tax-deductible. And some types of investments are taxable at various rates. In order to compare apples to apples, you have to tax-adjust both sides of the comparison. You have to know your marginal tax rates (and there is likely more than one). If your marginal rate on ordinary income is 35% (you can figure this out with tax software), and your debt interest is fully deductible (you can figure this out with tax software too), then a 4% debt is is really a (1-35%)*4% = 2.6% debt. If your investment return is taxed at your marginal tax rate and earns 6%, then after-tax it is really 3.9%. If your investment return is taxed at a 15% long-term capital gains rate, then that 6% return is really 5.1%. Your marginal tax rate on the investment could be even lower if you are able to defer some of those gains (such as with a tax-efficient stock mutual fund) or if you have offsetting depreciation (such as with a real estate investment.) And it would be zero if you’re investing in a tax-protected account. Now make your comparison.

In addition to those simple calculations, we also have to consider the other tax benefits of retirement accounts. For the typical attending physician in his peak earnings years, that mostly means a tax-deferred account like a 401(k). A typical physician should expect a tax arbitrage between his marginal rate at contribution and his effective withdrawal tax rate. 35% and 15% would not be unusual. That has the effect of boosting your investment return significantly as you basically started with a free 20% return in the account. In addition, that money isn’t taxed as it grows. That tax-protected growth may boost your return by another 0.5-2% per year. And if you leave it to a young heir, it can be stretched for more than a century. That tax benefit is awfully hard to pass up in order to get out of debt a few months earlier. Similar principles hold for a tax-free account like a Roth IRA, minus the tax arbitrage.

For the new attending physician, keep in mind you may be able to delay retirement account contributions. Instead of contributing to the 401(k) or HSA in August, you could pay down debt in August and contribute in December. You have until April of next year to get your IRA, SEP-IRA, and employer individual 401(k) contributions in. Yes, you lose the benefit of having that money start compounding in a tax-protected way right away, but at least you don’t lose that tax-protected “space” forever.

Clearly, it makes a lot more sense to carry debt in order to invest in a tax-protected account than to invest in a taxable account. When you’re maxing out all your tax-protected accounts, that’s a good time to take a look at the debts you have left and see if throwing some money at them would be wise. A 401(k) is a lot more valuable than most people think it is, and it is most valuable for high-income professionals.

Asset Protection

You should be familiar with the asset protection laws in your state, as it can have a serious effect on this decision. For example, in Texas and Florida, you have strong homestead laws. So it can make a lot of sense to pay down a mortgage as that money is protected from creditors. In my state of Utah, not so smart as only $40K of home equity is protected. But our retirement accounts get 100% protection. So where a doc in Texas might choose to pay down his mortgage, a doc in Utah could, just as logically, choose to invest in his cash balance plan instead, even if expected returns were similar.

You can be assured that your creditors aren’t going to take your student loans away from you, but money you use to pay them down also can’t be taken away from you, and since they’re not going away in bankruptcy, paying them off instead of investing in taxable is a smart asset protection move. Bear in mind that asset protection isn’t nearly as important as most docs think it is. The risk of having a significant above policy limits judgment that isn’t reduced on appeal is incredibly small.

Estate Planning

Retirement accounts are very useful for estate planning. By properly designating beneficiaries, that money doesn’t have to go through probate. Of course, if you expect to die any time soon, you probably don’t want to pay your student loans off, as they are generally forgiven at death (if you’ve refinanced, be sure to read the fine print to see if they’re assessed against the value of your estate.) Similar issues exist with disability as most student loans are forgiven in the event of permanent disability.

Cash Flow and Insurance

One of the best benefits of paying off debt is that your cash flow needs are lower. That allows you to carry less life and disability insurance to protect that cash flow. That could be worth hundreds or thousands per month. Now that we’ve paid off our mortgage, if I died, Katie wouldn’t have to come up with that $2,800 a month mortgage payment to stay in the house. She would only have to come up with $300 for property taxes and $100 for property insurance. Big difference.

# 7 If Unsure, Split the Difference

As you can see, sometimes an invest vs pay off debt dilemma is very straightforward to resolve. And other times it is complex, murky, and dependent even on your emotional feelings about debt. In those times when you’re truly unsure what to do, and discussion with those closest to you doesn’t help, just split the difference. Send some of the money into your mortgage or student loan lender and invest the rest and realize that you’re choosing between two very good things to do. Which you do matters far less than the percentage of your income going toward building wealth instead of being spent.

What do you think? What else should be taken into consideration when choosing whether to pay off debt or invest? How do you make these decisions? Comment below!

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31 comments

To help people sort through the 2-5 year dilemma of paying off their debt, I like to discuss people’s student loan Debt to Income Ratio (DIR).

Example: Debt is less than 250,000 and income is 250,000 = DIR of less than 1

If the DIR less than 1 I recommend they fill up all of their tax protected space before they put any remaining extra money towards their loans. They’ll likely still be able to pay it all off in 2-5 years given their low DIR.

If the DIR is > 1 – And particularly >1.5 – I recommend that they max out their 401K enough to get the match, and then put every extra dollar towards their debt. Once their debt is gone – or at least more manageable – they can then start investing in other accounts. But people with a DIR >1.5 are in a precarious place, if they don’t prioritize this debt. And that debt is a heavy burden that few people appreciate the gravity of until its gone.

Thanks for the thoughtful post. I really liked the part about protecting assets in various states (mortgage versus 401K).

Super important topic. I wish I had read this when I had finished. All of your points are helpful and the comments too. I ended up speaking for drug companies and put every dollar to my school loans. I think having a budget and living frugally is critical in freeing up cash to pay down debt. I sustained a sever e back injury and it changed by goals and view on life/debt. Other tips I have learned:

1- get an umbrella policy
2- freeze your credit
3- get a will/trust
4- get term life insurance
5- consider the Baby Steps by Dave Ramsey- it will guide you in your path to pay down debt and structure your wealth building.
6- have private disability insurance plan and increase it yearly if you can.
I am at the point where my mortgage and school loans are paid off, we pay cash for our cars and I sleep a lot easier. If ion don’t like not having debt, you can go back into it pretty easily!

I agree that the first thing would be to max out all out tax deferred retirement vehicles which should be not too hard to do on most physician’s salaries.

After that I think paying off all debt should be a priority with the excess money. I regret taking so long to pay off my student loans (17 years after I graduated medical school) and know I paid a ton more interest than I should because of it. I did take out a 30 year mortgage but ended up paying it off in 9 when I I did see the financial light.

Peace of mind being debt free is one of the best non-monetary rewards. Sure I probably would have come out financially ahead if I had invested it in the market instead but paying off my mortgage early was a very freeing experience.

You can reverse engineer the question to see what is right for you. If you had a fully paid off home, would you borrow against it to invest in the market? For those that do have a fully paid off home, I would say the vast majority wouldn’t.

I need to not look at my taxable balance for a while. Started about a year and a half ago after polishing off the loans, with the latest dips I’ve actually lost money on it so far. Trying to keep the long-term perspective in mind.

LizOB,
Keep in mind you never loose anything when the market dips. You only loose if you sell something for a loss. If you are in the accumulation phase, stop looking at the market. Right now, if it is down, that is a great time to put in money and buy stocks at a sale price. Stick to your investment plan regardless of what the market does.

“You only loose if you sell something for a loss. If you are in the accumulation phase, stop looking at the market. Right now, if it is down, that is a great time to put in money and buy stocks at a sale price. Stick to your investment plan regardless of what the market does.”

I would suggest your definition of loss is inappropriate for a high income client or anyone’s portfolio.
1) Mark to market is an extremely important concept in understanding and measuring one’s wealth.
2) Realized losses and unrealized losses have different impacts from a tax and investment perspective.
3) Permanent loss and temporary decline in value are two completely different financial occurences. How you deal with them has a tremendous impact from a tax and investment perspective. Deal with permanent losses.
Stick with your investment plan and modify it ONLY as needed due to permanent losses. Selling due to a temporary market decline “assures” a loss is permanent rather than temporary.

“You loose only if you sell” is not really your intent but I would suggest “hope for recovery” is not part of a wealth building plan.

Liquidity: when you are deep in debt it is sometimes acceptable to have a minimal emergency fund (fancy name for cash on hand) but when you are getting to that fuzzy area of mortgage vs taxable many might desire the security of more liquidity.

Focus: why do you advise to pay off school loans within 5 years? The math people are ready to fight you. The reason you do is because you are alluding to the power of focus. And this is really the power behind Dave Ramsey (who definitely fails or misleads in the math department). Seeing success motivates even very smart people to do more.

So this the crux of my personal debate. Early career physician with paid off school loans, filled HSA/bdRoth/i401k. Do they start building the taxable empire that has the extra benefit of liquidity or do they pay off the mortgage with a focused debt demolition? I think you say split the difference but that hurts the focus aspect. In reality didn’t you build taxable until you could wipe the mortgage in one year? Both ways are good but just seeking the best.

I couldn’t build taxable for many years because my ratio of tax-protected space to income was so high. It wasn’t until WCI started making some money that we had to face that dilemma. And yes, we favored taxable for a year or two before looking at the debt and comparing it to our net worth/income and realized that arbitraging that was just silly. At that point, we paid off the last 2/3 of the mortgage in 2 or 3 payments over about a year.

Honestly I think there’s room there for some differences of opinion. And if you regret your decision, it’s usually reversible. For instance, if you put a bunch of money in taxable, you can pay off the mortgage with it. If you paid off your mortgage, you can take out a HELOC and invest.

I agree that the decision is about more than just math. Being debt free is a luxury. Just like someone might choose to drive a Lamborghini instead of a Honda, some might choose to pay off their mortgage in their 30s instead of their 50s. Few things feel as luxurious as owing nothing. Having extra cash flow and needing to bear less risk is a great recipe for sleeping well at night.

I agree. It’s a luxury to not have to maximally leverage your life in order to meet your financial goals. Those who advocate for maximum leverage sometimes forget that the goal isn’t to gain as much as possible but to meet your own goals with the minimal amount of risk required.

Great post on a debate that will never end. I especially enjoyed the part about asset protection because the #1 target for creditors will be taxable accounts. I do seperate student loans from mortgage because I don’t live in a state with a homestead protection so after a taxable account the next big target would be a paid off home.

Asset protection is one of those things that I think is important to point out, but I try not to emphasize too much because docs already focus on it way too much given the tiny risks we face in this department. Doctors fear the “above policy limits” judgment without realizing # 1 how rare they are and # 2 the fact that even when a judgment is above policy limits, the doc is usually only out $50-200K, not $50 Million. How much time/effort/money are you going to spend to protect against a 1/10,000 chance of having to pay out $50K? I’m not going to spend much. Sure, I’ll pay for malpractice and an umbrella policy and put real estate in LLCs and title my house properly and preferentially max out retirement accounts but I’m not going to put everything in my wife’s name, buy whole life insurance, or fund an offshore trust.

Great post. Even as a new blogger, this is a common question I get all the time. In fact, the question got asked at work this morning by a redident. Rightfully so though. Especially based on our profession, most of us got here with loans.
Will sure direct them to this page.

I know that everything is not about rate of return but the mathematician in me will not let it rest. The difference might not be much on the long run, but I love to optimize anyway I can.

The asset protection part of it is something I will have to look into, especially in terms of mortgage. No house yet, still in the living like a resident phase, but will keep it in mind.

I frequently hear talk in the financial world about “debt arbitrage” and “investing instead of paying down debt”…but largely the professors of this advice leave out risk and behavior from the equation. Even if you come out a little behind paying off a 2% interest loan…it’s likely you will use the money to accrue wealth instead of splurge.

It reminds me of the joke about a doctor and his patient:

Doctor: how much do you smoke?

Patient: 2 packs a day

Doctor: for how long?

Patient: 20 years

Doctor: do you realize that if you took the cost of your cigarettes and invested it, you could buy a Ferrari?

I’m a little confused how how this fits into the idea of putting 20% of your income into savings. If you pay extra into your mortgage do you count that in your savings rate or do you only apply retirement savings to calculating your savings rate? While both improve your net Worth, only one can be spent after retirement. I have maxed out all tax advantages accounts But that does not total 20% of my income. Is it reasonable to now start to prioritize paying off my mortgage with a 4.8% interest rate over creating a taxable account?

I’m a little confused how how this fits into the idea of putting 20% of your income into savings. If you pay extra into your mortgage do you count that in your savings rate or do you only apply retirement savings to calculating your savings rate? While both improve your net Worth, only one can be spent after retirement. I have maxed out all tax advantages accounts But that does not total 20% of my income. Is it reasonable to now start to prioritize paying off my mortgage with a 4.8% interest rate over creating a taxable account?

I recommend 20% for retirement. Let’s say you want to commit 30% of your income to building wealth and you’ve already maxed out retirement plans. Should you use that extra 10% to pay off the mortgage or invest in taxable? That’s the debate.

Hope that helps.

If you can’t get 20% of gross into retirement accounts, then I suggest you invest the rest of that 20% in a taxable account before looking into paying off a mortgage.

I agree that risk must be taken into account when evaluating an expected investment return 8% vs. paying a 7% debt. But of course, part of that ‘risk’ is that the return could be higher than 8%! I do feel like this potential upside is sometimes ignored. And from a long-term perspective, all other things being equal (taxes, not needing the money in the short term, etc.), I tend to favor the higher expected value.

I wish everyone would make the choice of one or the other or both. But all too often I see them agonize over this and then decide not to pay off the debt. But then they don’t invest the money either, they spend it on a trip to Paris or a new Tesla. Then they think they made a good decision to not pay off the debt because they “could have” made more money investing. If only they would have read The Doctors Guide to Eliminating Debt before they went to Paris. Or at least on the plane trip over so they can do better next year.

My tax-protected investments are max’d and have extra to invest into a taxable brokerage account or pay off real-estate debt. I became an accidental landlord in 2011 after moving from a primary residence to another state with job change. Given that home was underwater, we kept it as a rental, and now the expenses (including mortgage principle and interest) are essentially balanced by rental income, thus paying for itself and cash-flow neutral. For tax return (mind you I need to file a separate state return because rental is in a different state than primary residence) the rental is a loss with depreciation so no state income tax bill. Rental mortgage interest is 4.25% (30 yr fixed through 2042) , slightly higher than my current primary residence at 3.25% (30 yr fixed through 2042).

If I pay off mortgage debt on this rental, sooner or later this will start generating income and I’ll be taxed at a marginal rate on this mortgage income. Is this a consideration when paying off this type of debt? And would it favor maybe paying primary mortgage (albeit a lower rate)? At this point, I’m in favor of splitting between taxable brokerage investment account.

I would pay off the primary house, not the rental. The rental interest is 100% deductible and your home is not. The rental will be paid off when you sell it, and you will, since you were a reluctant landlord and it is out of state. A paid off home is a huge security blanket and you don’t get that from a paid off rental. That is if these are the only two debts to choose from.

Great discussion of a perennial debate. We paid off all education and consumer debt about 2 years from the first big paycheck. We could have of put a lot of cash in a taxable account, but we simply wanted to be debt free. It feels awesome. Agree with the others that debt reduction versus taxable is a win win problem to have, you are building wealth either way. We did both once we were down to low interest debt (<4%) then saw how doable being debt free was with a resident's lifestyle and paid it down aggressively. Living like a resident covered a lot of past mistakes. The other side of the coin was not making big rock mistakes, like a 0% down mansion or G wagen V12, We thought about both. Thanks for the great post.

I am currently at “split the difference”. Student loans gone, already max’d out on tax-advantaged space, so it comes down to taxable vs mortgage with extra cash. Taxable is nice for the liquidity, mortgage is nice because I don’t want to be paying it for its entire term. They are both good things to do.

Great post and very helpful with actual math behind the debate! Isn’t it also important to consider that there is value in investing over time, a little bit at a time over decades as opposed to a bunch concentrated to just a few years, as this decreases risk in the stock market variability? This is one distinct disadvantage physicians have in starting investments later in life.

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